European Journal of Business and Management www.iiste.org ISSN 2222-1905 (Paper) ISSN 2222-2839 (Online) Vol.6, No.36, 2014 1 An Evaluation of Credit Appraisal Techniques Adopted by Commercial Banks in Kenya in Lending to Small and Medium- Sized Enterprises Milcah Chepkorir 1 Kirochi Edward Osiemo 2 Joseph Mwanza Wambua 3 1. Marist International University College P.O. Box 24450 Karen 2. Wisdombay Publishers Limited P.O Box 21800 Nairobi 3. Marist International University College P.O. Box 24450 Karen csmilcah@gmail.com Abstract The main purpose of this study was to evaluate the credit appraisal techniques used by commercial banks in Kenya in lending to small and medium sized enterprises. The study sought to achieve two specific objectives: to determine the credit appraisal techniques used by commercial banks in Kenya in lending to small and medium sized enterprises and establish challenges facing banks in using the applicable credit appraisal techniques. The study adopted a descriptive research design and the target population of the study included 41 commercial banks that have branches within Nairobi’s Central Business District. Primary data was collected by means of semi- structured questionnaires. The data was analyzed using multivariate regression analysis as well as percentages and frequencies. The findings reveal that the following attributes were considered to be of great importance when making lending decision: strength of income statements, strength of the balance sheet, long histories, quality of accounts receivable and inventory, history of the principal owner and transparency of firms through provision of certified financial statements. 1.1 Introduction and Background The main concern of both profit and non-profit private or public firms is to offer best goods and services to their customers. This can only be achieved when there is a sound relationship with various stakeholders. However, the business environment in which firms operate is increasingly becoming uncertain but also more tightly interconnected. This requires a threefold response from these organizations. They are required to think strategically as never before, need to translate their insight into effective strategies to cope with their changed circumstances and lastly, to develop rationales necessary to lay the groundwork for adopting and implementing strategies in this ever-changing environment (Bryson, 1995). Bryson’s observation implies that organizations operate within a wider environment that is composed of a number of variables: political, economic, socio- cultural, technological, ecological, and legal. Consequently, any change in any one of these variables is expected to have far-reaching implications in the way organizations operate. Commercial banks being financial intermediaries that deal with the mobilization of funds from savers and the accumulation of the same in pools for disbursement to those requiring funds for investment, must adopt various techniques that can enhance their success (Gordon et al, 2002). Thygerson (1995) asserts that commercial banks perform the role of servicing and portfolio risk management. Stiglitz (1993) identified five roles of financial institutions: they act as intermediaries between savers and borrowers; they relieve the savers the risk of lending, they therefore encourage savers to lend without bearing the associated risk; they provide facilities such as savings deposits which act as savers investment. They therefore provide investment opportunities for savers while at the same time mobilizing capital for ultimate investment; they play the role of liquidity adjustment in the financial market by taking surplus liquidity and providing it when needed; they provide savers with experts in financial management to manage their future funds. Such experts are usually unaffordable by individual savers. The banking sector in Kenya is composed of commercial banks, non- bank financial institutions, Forex Bureaus and the Central bank of Kenya as the regulatory body. Currently the banking sector has 42 commercial banks and one mortgage finance company. Commercial banks and Mortgage Finance companies are licensed and regulated under the banking Act, cap 488 and prudential regulations issued there under. Each of these commercial banks have their own tailor made appraisal techniques that are applicable when lending to various customers including the small and medium sized enterprises. According to the World Bank Group definition, SMEs comprise of enterprises with up to 300 employees and total annual sales of up to US$15 million while the European Union define SMEs as enterprises which employ less than 50 employees and with turnover of less than US$10 million. McCormick’s (1993) empirical analysis of Nairobi’s small scale manufacturers used four categories: very small enterprises have six or fewer workers, small enterprises have 7-10 workers, medium sizes firms have 11-50 workers, and large enterprises have over 50 workers. However for the purpose of this study SMEs will comprise enterprises of up